Wednesday, February 1, 2012

Types of Bank Loans - Term Loans

Following on from a previous post on overdrafts, this article focuses on term loans. A term loan essentially provides an agreed lump sum over a set period, usually referred to as the “term”, requiring payment at or by the end of the term. Such loans usually have a term of more than one year and will often be for more than five years.

Common features of term loans

Term loans are usually committed facilities. A “committed” facility is a facility where once the facility agreement has been executed, the lender is under an obligation to advance money when requested by the borrower subject to compliance with certain pre-agreed conditions by the borrower.

With a term loan, a borrower is usually permitted a short period after execution during which it can draw down funds. This is known as the “availability period”. Additional funds may be drawn down in stages or “tranches” as agreed under the loan facility and at the borrower’s discretion. Each tranche has its own pre-agreed conditions which need to be satisfied and its own availability period. If funds are not drawn down during the relevant availability period, such funds cease to be available and the commitment is automatically cancelled. The use of tranches gives the borrower greater flexibility and greater control over the amount of money borrowed and, therefore, the amount of interest paid.

When the borrower decides to exercise its right to draw down during an availability period, it must give notice to the lender (usually two or three days’ notice) so that the lender can get the required funds. The borrower must choose the first interest period. At the end of the interest period, the borrower pays interest on the amount borrowed and chooses the next interest period.

The loan will be repayed according to the repayment schedule in the facility agreement. The most common methods of repayment are:
• Amortisation: repayment, in equal amounts, is spread evenly over the term of the loan;
• Balloon repayment: repayment is made in instalments and the final instalment is the biggest; or
• Bullet repayment: repayment is made in a single instalment at the end of the term of the loan.

In addition, it may be possible for the borrower, on giving sufficient notice, to prepay
all or part of the loan (that is, before the dates specified in the repayment schedule), because, for example, it may no longer need as much money as it first borrowed. It may have to pay a fee to the lender to compensate it for the lost interest the lender would have received had the money still been outstanding; this is known as a “prepayment fee”.

Advantages of a term loan

A term loan provides the borrower with the certainty of a fixed repayment schedule. This contrasts with the on-demand nature of an overdraft.

The use of tranches provides the borrower with some flexibility, which may be further increased if the term loan allows the borrower to draw money in different currencies. Interest on a term loan is likely to be lower than that paid on an overdraft and will either be at a fixed rate or, more commonly, will be set at an amount (known as the “margin”) above the relevant LIBOR (London Interbank Offered Rate).

Disadvantages of a term loan

Commitment fees may be payable on a term loan as they are committed facilities. The commitment fee is calculated as a percentage of the undrawn funds that the lender has to keep committed to the borrower from time to time. The fee covers the costs incurred by the lender in committing funds to this loan which it cannot then lend to anyone else.

One feature of a term loan is that once it has been repaid, it cannot generally be reborrowed, unlike a revolving credit facility (which will be considered next month) or an overdraft.